The energy price crisis that began with rising gas and electricity prices in 2021 turned into a security of fossil-fuel supply crisis following the Russian invasion of Ukraine. The combined price and security crises add urgency to the climate crisis that has to date been the primary motivator for the energy transition.
The new crises are a wake-up call that can and should accelerate the energy transition.
The energy transition, and the avoidance of a continuing fossil-fuel crisis, means that vastly expanded amounts of electric power generation and consumption will replace fossil-fuel production and consumption. To avoid potential future problems concerning the reliability of electric power supply will require in-depth thinking on a redesign of current electricity markets. This will be needed to elicit necessary private sector investment in renewables generation capacity, power storage technology, new energy consumption and management equipment, and various other technologies. In the meantime, it is important to avoid decisions that will slow the energy transition or increase its costs.
The crises
Since the first quarter of 2021, global energy prices have been rising, especially in Europe. In particular, natural gas spot prices in Europe increased sixfold. This led to a similar sixfold increase in wholesale electricity prices, mainly because natural gas is the marginal source of electricity in many countries. These gas and electricity price increases were unprecedented.
The Russian invasion of Ukraine and the war introduced a new dimension to the crisis, namely that of geopolitical insecurity of supply. The EU declared its intention to end its dependence on Russian fossil fuels and began looking for alternatives. Russia began to cut supplies of natural gas to EU countries unwilling to meet Russian ruble payment requirements, further exacerbating concerns over security of supply, especially of natural gas.
Energy policy and transition
On the one hand, these crises have changed the EU's energy policy. Of the objectives of the energy trilemma (of environment sustainability, security of supply and affordability of energy), the two crises have led to more attention to security and affordability and less to sustainability. This implies a detour on the path to net zero as emissions rise (with coal replacing gas) and governments struggle financially to deal with the other two objectives.
On the other hand, the new emphasis on security confirms an under-appreciated benefit of the energy transition and offers an opportunity to justify its acceleration. The war should be a wake-up call about the insecurity that comes with dependence on fossil fuels. The way to create a unity of purpose in support of the energy transition is to emphasize that it is the only feasible energy security strategy. Concern over the issue of security can help win the support of the security lobby (including military and intelligence services) for the energy transition, and can help justify the costs of realizing the transition.
It is important to note that this crisis has been brewing for some time. Saudi Arabia, Iran, Venezuela and other OPEC members, along with the US frackers and their banks, manage resources to maximize profitability, which implies restricting supply. In addition, major oil and gas companies are reluctant to invest heavily in E&P that might not start producing until such time as CO2/methane restrictions become binding. Short-sighted strategies towards Russia (e.g. Nord Stream 1 and 2) are a further reason that this crisis has hit so hard.
REPowerEU offers several measures to reduce dependence on Russia and fossil fuels in general, but the most important measures from the perspective of decarbonizing the energy system have to do with the penetration of renewable energies in the electricity sector, the electrification of demand and the development of decarbonized gas, in particular green hydrogen. The challenge will be to adopt policies that facilitate and can accelerate the energy transition.
Markets and government intervention
Governments will of course play a critical part in the energy transition, especially through energy system and network planning, support for new technologies, competition policy, protection of vulnerable consumers and ensuring a just transition.
To facilitate the transition to the electricity system of the future, there are two issues that deserve more attention from governments than they have received to date: agreeing a new market design that will ensure security of decarbonized electricity supply; and avoiding government interventions in the power sector that will raise the cost of the transition.
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With respect to electricity market design, it is important to recognize that we are replacing security of fossil fuel energy supply with energy security based on renewable electricity supply. This requires massive investments in renewable power, mainly solar and wind. However, because these renewables are intermittent, the system also requires investments in flexible energy resources to: (1) supply energy or reduce demand when renewables are not generating; and (2) to store energy or increase demand when renewables are surplus to demand. In Spain’s current electricity system, fossil-fired and hydro generation provide almost all of the flexibility needed, from rapid response for a short duration to slower response for much longer duration (weeks or even seasons).
In the new decarbonized electricity system, flexibility will come in part from traditional resources, notably hydro, but increasingly from new resources, including battery storage, concentrated solar power, smart grids and flexible demand. A key feature of the new system will be the high level of decentralization of these resources, many of which will be behind consumer meters; making demand flexibility an especially important resource in the new system.
Designing markets that will elicit efficient investment and operations in this new system is critical and complex. One thing is, however, clear to most experts, namely that the current market is not adequate. At the very least, it will need important incremental reforms, but more likely very substantial ones, to address the following challenges: (1) recovering fixed investment costs when most generation has zero short run marginal costs, which could lead to energy market prices that are too low to justify investment; (2) ensuring security of supply when most generation is intermittent; and (3) supporting the growing participation of consumers and their representatives in providing energy resources and flexibility. Building the markets of the future must begin soon because investors today want clarity with respect to what will determine their revenues for the next 15-25 years.
Meanwhile, it is very important not to introduce policies that can slow down the transition or raise costs. Two examples serve to make the point; one related to consumers and the other to investors. First, governments must obviously intervene to protect the most vulnerable consumers. However, some forms of intervention are unhelpful. In particular, electricity markets currently send unwelcome but important information. High wholesale and retail prices convey the message that consumers should reduce demand, which will lead to lower prices for everyone, lower CO2 emissions and less revenue for Russia and other gas suppliers. Governments have many other tools at their disposal to assist the most vulnerable consumers, for instance financial transfers that do not distort price signals. But they should use those tools carefully, resisting the short-term political temptation to lower prices. They should be especially careful not to extend relief to consumers that are not vulnerable, for instance by reducing VAT on electricity sales.
A second example is related to investment. Of course, governments must intervene to support investment, especially for technologies that are not yet economic. However, governments should ensure that markets are designed to encourage competition by private investors in economically viable technologies, thereby reducing systems costs and final prices for all consumers. That objective is undermined when governments intervene in a way that creates or reinforces the investor perception of political risk. For instance, capping prices not only distorts price signals; it also make investors nervous about future revenue streams, leading them to require a higher return on investment to compensate for political risk. That raises the cost of the transition.
Conclusion
The current energy crisis has reinforced the case for an energy transition away from fossil fuels. However, the new decarbonized and decentralized electricity system raises its own security of supply challenges. New market designs are needed to address those challenges and to incentivize the appropriate mix of investments. Furthermore, while protecting the most vulnerable consumers, governments should avoid interventions in the short term that weaken the incentive for consumers to reduce demand and that reinforce investor perceptions of political risk.
(Here, the Spanish version)
